Debt

A Silly Trap When Trying to Pay Off Debt

I have had numerous clients tell me that they are paying off their debts early, whether it is a student loan, car loan or mortgage, which is very admirable. However, they really aren’t paying off their loans early. How can this be and why?

The reason is simple. They are not actually paying off their debts, but prepaying their regular monthly payments. The assumption is that if you make extra payments then those extra payments will go directly towards principal, which in essence will reduce your loan balance. It sounds logical, but usually the loan company will apply these payments towards future bills, so in reality no extra principal is being paid. They are just considered prepayments.

One way of determining if your extra payments are being applied properly is to look at your current monthly statement to see if your payment amount is either -0- or shows a lower amount than normal. If this is the case, then your extra payments are not being applied towards principal.

The proper way and easiest way to ensure that your extra principal payments are being applied correctly is to specify that your extra payment should be applied towards principal. It is best to do this online and then check your activity once the payment settles to confirm this.

It’s not right, but when it comes to finances you must be extra careful and do not make any assumptions!

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Is Debt Good or Bad?

What are we to believe? Is debt good or bad? On one extreme are some financial pundits that say to go into debt and use other people’s money to make money, and on the other extreme are experts that believe that any form of debt is bad. Who should we listen to?

Ignoring the rare exceptions, most successful people have incurred some form of debt either personally or through their business, and if they did not incur this debt then they would most likely not be in the position that they are in currently, even if they have now paid off all of their debts. Let’s look at some pros and cons.

Pros of debts: Without incurring debts, virtually no one in this expensive area would be able to purchase a house. If you were debt averse and had to save up for your house to pay cash, then you may never get there. If a $500,000 house appreciates by 3% per year on average (let’s ignore significant ups and downs to keep the point simple), then just one year later you would need to save an additional $15,000 to purchase your home. You may never get there.

If you want to expand your business or start a new one and need capital to build out your office or purchase equipment, then a loan is most likely needed. Even the best savers have a hard time saving up the significant sum that is needed to do so. The same applies to investment properties.

Unfortunately, you most likely need to incur some debt to finance college or purchase a vehicle.

Cons of debt: Debt is not without risk and I am a big proponent of proceeding cautiously and wisely when incurring debt. Here are several pitfalls of debt:

Over leveraged: If you incur too much debt than you may not able to meet your payment obligations. This is especially true if and when there is a slow down in the economy and/or your business. Think of debt payments as taking from your future income, but you really never know what your future income will be. If you find yourself with tons of debt then you need to closely examine your spending and look for ways to increase your income.

Increases risk: Debt amplifies the risk of any financial endeavor due to a decrease in cash flow from making debt payments and the financial obligation of the debt. Most debt is personally guaranteed, even if it is for business. Trust me when I say that a bank owns you when you take out an SBA loan. They may even put a lien on your children, but that may just be a rumor.

Makes you spend more (much more): Surprisingly, this isn’t mentioned too often as most people only consider the monthly payments, interest rate, and length of a loan. However, debt makes you less cautious when spending and investing money, even if it is for something productive, such as  purchasing equipment for your business or buying rental properties. The end result is that you wind up spending more than you anticipated. Why do you think so many companies offer enticing payment plans for just about everything? If you have the resources to pay cash, then it probably makes sense to do so.

Increases costs: Even loans with low interest rates increase your costs due to both interest and fees, which can be very significant.

As you progress on your financial journey, then a noble goal is to become debt free. Ideally, you should try to avoid debt when possible, but it may provide you with a much needed boost to get you started. Just do not over do it.

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How to Prepare for & Prosper from the Next Recession

We are currently in one of the longest economic recoveries ever recorded. That is excellent news, but on the flip side, we are due for a recession. Who knows when that will happen, but there are steps to take to prepare yourself and possibly take advantage of any future downturns:

Don’t Live on the Edge: Before making a major purchase or change in your life, calculate the costs and risks of your actions. For example, before you assume that you will purchase a fixer upper, make massive improvements, then resell it for a large profit, you should calculate different scenarios. Instead of just looking at the best case scenario, calculate a likely outcome and then also a worse case scenario. If you won’t be able to handle the worse case scenario, then may be you should pass up the opportunity. Don’t take my word for it, but try to remember what happened during the last recession.

Build Up Cash: Sometimes cash makes people anxious  as they feel that it is just sitting there practically earning nothing ,and they are missing out on appreciation from the stock market or some other investment. Be patient and know that if your income gets cut in half or you lose your job and collect the paltry amount of unemployment benefits, then you will have a cushion. On a positive note, when there are downturns in the economy it tends to present itself with opportunities to purchase real estate at a discount, buy a business,  or to invest in the stock market at depressed prices, which all increase your returns.

Pay Down Debts: The lower your debts, the lower your risk, and the more cash flow you have available. You’d be surprised by how much less income you need to live if you eliminated some debts.

Line of Credit: If you don’t have a large cash cushion or don’t see one in the near future, then a line of credit can be a good second option. The caveat though is to make sure that you use it wisely and don’t overspend just because you know that you have access to funds.

Market Your Business and Yourself: Employees should be prepared by having their resumes updated and keeping in contact with their network. Business owners should continue to market their business for two reasons: First, if they increase profits then they will be able to weather the downturn better both before and during. Second, many businesses reduce marketing when there is a downturn, but if you increase marketing then you will stick out and increase your chances of prospering during the downturn.

All of these tips can help you to survive a recession, and they can also be applied even if there isn’t a recession. Don’t be afraid.

Don’t Be a Co-Signer Unless You Want to Pay Someone Else’s Debts

Your friend, child, brother, or parent can’t get a mortgage or a car loan so they ask you to be a co-signer. Of course you will be a hero and co-sign for your loved one! But beware of the dangers before doing so.

In reality, the lender is assuming that the odds are fairly high that there will be a default on the loan, otherwise, why would they need someone else to co-sign on the loan? There are certainly many situations that the loan never goes bad, but why take such a chance? Consider this:

If the borrower defaults on the loan, then your credit will take a hit because you are personally responsible for the loan. The lender may also come after you for payments on a loan that you never benefited from. Actually, you had almost all of the risk without any real benefit.

If you are familiar with Murphy’s law, then you know that what can happen will happen. So, what if you are ready to obtain a mortgage or finance a car and then find out that the loan you co-signed went bad? You may not qualify for the loan for yourself or the terms may not be as favorable as they were originally.

One last item to consider is the damage to the relationship once a co-signed loan goes bad. As Polonius said over 400 years ago in Shakespeare’s Hamlet, “Neither a borrower nor a lender be; For loan oft loses both itself and friend . . .” Even thousands of years before Shakespeare numerous bible versus were also written to warn against co-signing such as Proverbs 22:26-27 and Sirach 29:16-18.

Are You Overwhelmed By Debt?

Why or how do so many people get into trouble with debt? When does it become a problem? There are so many reasons, such as job loss or, health problems, but overall it is a disconnect between income and spending, and not enough focus on financial management.

I’d like to share a few simple ways to reduce your debt and help to minimize its use in the future. If you keep it simple, you are more likely to be successful.

Stop incurring more debt: You can’t get out of debt if you are still using your credit cards. Do not increase your debt or you will never get out.

Emergency fund: By building up an emergency fund, you are less likely to take upon more debt for something unexpected. For now, it can be around $1,000 to start. Ideally, you will want to work towards 3 to 6 months worth of expenses, but it doesn’t make sense at this point to save $10,000 and simultaneously have a $10,000 credit card balance.

Budget: If you are serious about reducing your debt and improving your financial situation, you need to take the time to make a budget. You can use software, such as Excel or Quicken, but a very simple and effective way is to use envelopes. For example, if you are paid weekly by your employer and spend an average of $200 a week on groceries, then place $200 in an envelope labeled groceries. When you go food shopping, bring this envelope so that you can only spend$200 or less. This can be done with all other expenses. It is simplistic, but if it is done right it is extremely effective. My father taught me this one.

Know what you owe and prioritize: Make a list of all of the debts you owe, including credit cards, auto loans, equity loans, mortgages, student loans, etc. Now you need to work at chipping away those debts. The rational place to start is with the highest interest debt, but I don’t recommend this. You should actually try to pay off the smallest balances first because it will give a sense of accomplishment. Once the smallest is paid off, then use that payment toward the next balance. Finances are extremely psychological, as most of our financial decisions are emotional-based.

These few steps are a good place to start to manage and reduce your debt. If you are serious about debt elimination, you will not look for shortcuts, but rather ways to increase your income to pay off your debt sooner and take control. Focus and simplicity are the keys. If you need more help you can contact my office. Additionally, there is an excellent book on this topic that parallels my thoughts on debt, entitled “The Total Money Makeover” by Dave Ramsey.

Is Debt Really That Bad?

Is it bad to have debt? Should you pay off your debt early? What about credit cards? These are all questions to consider regarding your personal and business finances. Let’s take a look at the good and bad.

If you view debt as a financial tool to help you to achieve your goals, then debt is a good thing. Some benefits of debt:

  • Virtually all homeowners take out a mortgage when purchasing their first home; otherwise they most likely would not be able to purchase a home.
  • A loan for your business may help you to expand your business to help it grow, such as an equipment loan or a line of credit to use during lean times.
  • By using debt it may help you to conserve your cash so you do not have to deplete your savings to purchase a vehicle, for example.

Now, the ugly side of debt:

  • If the interest rate of your debt is very high, then you may end up paying much more than the original loan balance. This may be true with credit cards.
  • Debt payments that are too high compared to your income will put a strain on your finances.
  • If your income goes down for an extended period of time, while having a lot of debt, may result in bankruptcy, foreclosure, and a poor credit score.